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Why So Many Investors Want These Big Losers to Recover

Volatility bets still attract investors despite huge losses.

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

After having set new records throughout much of the past few months, the S&P 500 (SNPINDEX:^GSPC) took a break from its bull-market rally over the past week, falling just over 2%. Even though the stock market has repeatedly managed to bounce back from minor dips to push ever higher, many investors are making big bets on increased levels of volatility in the market -- and the huge losses they've suffered so far still hasn't made them lose their resolve.

Why volatility trackers have been losers this year The losses that investments linked to volatility have suffered have been truly massive. The volatility-tracking iPath S&P 500 VIX Short-Term Futures ETN (NYSEMKT:VXX) has lost more than 50% of its value so far this year, while the leveraged VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX) has plunged more than 80%. Yet even as these investments have seen their share prices fall, investor interest has remained strong, with the iPath ETN having pulled in more than $850 million during just the first five months of the year.

The reason is simple: choppiness in the stock market simply hasn't led to sustained periods of heightened investor anxiety. Even during the months of May and June, when a big jump in interest rates led some to believe that the Fed's imminent exit from its quantitative easing policies could lead to a sustained market correction, modest losses in major-market stock benchmarks were quickly followed by pushes to new highs. As the market continued to dodge potentially catastrophic events, volatility levels fell, causing losses for ETN holders.

The appeal of volatilitySo why do investors continue to gravitate toward volatility-linked products? There are likely two reasons, with each appealing to a completely different set of investors.

On one hand, volatility-linked investments act like an insurance policy against heightened volatility. So even if they tend to lose value during calm periods, some investors are comfortable with those losses as long as they feel certain that they'll earn big gains from volatility ETNs if the market crashes and sends the rest of their stock portfolios falling.

On the other hand, some speculators see volatility ETNs as a lottery ticket. Sure, you'll suffer complete losses for a long time when no crash happens -- but when it does come, you hope that the payoff will make up for all the losses you've suffered along the way.

It's obviously impossible to know who'll end up on the right side of that debate. But one thing is clear: the only investors winning the volatility bet are those choosing the inverse side of the trade, with the VelocityShares Dailiy Inverse VIX ETN (NASDAQ:XIV) posting gains of more than 60% this year. As long as there's no big market decline, that trading pattern is likely to remain intact.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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